The Secret Word: Deflation - And the Next Five Years of Financial Turmoil

The following is a sample from Elliott Wave International's new
40-page report, The State of the Global Markets - 2013 Edition: The Most Important
Investment Report You'll Read This Year. This article was originally published
in Robert Prechter's July 2012 Elliott Wave Theorist.

In the first five months of 2012, there were 20 times as many Google searches
on "inflation" as there were on "deflation." This is down from a ratio of
50 times in June 2008. If any theme has been overdone over the past six years,
it is the theme of inevitable inflation if not hyperinflation.

Inflation reigned for 75 years, from 1933 to 2008. People are so used to it
that they cannot imagine the opposite monetary environment. Bullish economists
have been calling for recovery, which means more inflation, and bearish advisors
have been calling for a crash in the dollar, which means hyperinflation. No
wonder those are the terms on which most people have been searching.

But only one word allows you to make sense of what's going on in the world,
and inflation is not it. The secret word is deflation.

Deflation explains:

why interest rates on highly rated bonds are at their lowest levels in
the history of the country;

why the velocity of money is the lowest since the 1930s;

why huge sectors among investment markets are down over 40%;

why the Consumer Price Index (CPI) just had its biggest down month since
2008;

why Europe is in turmoil.

Here are some details: Ten-year Treasury notes pay out less than 1.5% annually,
their lowest rate since the founding of the Republic. Treasury bills yield
essentially zero, their lowest level ever. The velocity of money failed to
rise during the past three years of partial economic recovery, and it recently
made new lows. Real estate prices have fallen 45% in the past six years. Commodity
prices -- as measured by the CRB Index -- are down 39% over four years. This
group includes oil and silver, two of the most hyped investments of the past
decade. Remember in March when articles quoted analysts calling for $5, $6
and $8-per-gallon gasoline? In just three months since then, gas prices have
fallen 15%, knocking the CPI into negative territory.

Deflation also explains why European loans are at risk, why Germany is tapped
out, why Greeks are protesting in the streets, and why U.S. corporations'
overseas profits are down. Deflation lets you make sense of the world.

What is deflation? Economists define it three different ways, but I find only
one definition useful: Deflation is a contraction in the overall supply of
money and credit.

Why must deflation occur? Answer: There is too much unpayable debt in the
world.

As argued in Conquer the Crash, it ultimately does not matter what
the authorities do; they can't stop deflation. This prediction is being borne
out. Since 2007, the Fed has monetized $2 trillion worth of debt; the federal
government has borrowed another $7 trillion; and it has pumped out $1 trillion
worth of student-loan credit. Yet real estate and commodities slumped 40%
anyway.

These drunken-sailor-type policies have indeed succeeded in nearly maintaining
the overall volume of money and credit. But in the long run you can't fight
a systemic debt overload by piling on more debt. The Fed and the government
are shifting the burden of trillions of dollars' worth of debt obligations
from reckless creditors onto innocent savers and hapless taxpayers. The ploy
might work if the public's resources were infinite, but they aren't. Perhaps
this policy temporarily prevented a series of big institutional disasters,
but it was only at the ultimate price of a gigantic public disaster.

Such actions have become politically less palatable. Some observers realize
that the student-loan program of lending at below-market rates is exactly
the model the government used for housing loans, which ended in a spectacular
bust. Others know that the government cannot continue to borrow at the current
pace and expect to stay solvent. Politicians on both sides of the aisle are
tired of the Fed's bailing out of highly leveraged financial-speculation institutions.
But whether these policies continue or are curtailed is irrelevant to the
outcome. If the government slows its borrowing, the overall value of debt
will fall. If the government maintains or increases its present pace of borrowing,
interest rates will eventually turn up, and the overall value of debt will
fall. There is no escape from deflation.

Ironically, investors in the past decade have been doing exactly the opposite
of preparing for deflation. Convinced of perpetually rising prices, they have
bought every major investment. They chased real estate up to a peak in 2006.
They bought blue chip stocks into the high of 2007. They pushed commodities
up to a peak in 2008. They chased gold and silver up to highs in 2011. And
through spring 2012, they continued to buy stocks and commodities on any rumor
that promised inflation: European bank bailouts, Operation Twist, the Greek
election, Group-of-8 summits, Fed meetings, Bernanke press conferences, improved
economic numbers, predictions of QE3, central-bank interest-rate cuts, you
name it. Meanwhile, the U.S. Dollar Index hasn't made a new low for four years.
During deflationary times, cash is king, and by far most investors have chosen
to own anything but cash.

Deflation is still not obvious to the majority. Even now, most economists
expect continued recovery, mild inflation and a rising stock market. But the
essays on deflation.com are 180 degrees apart from conventional thinking.
It may be too late for you to get out at the top, but there's still time to
learn how to sidestep the worst of the crunch.

People will be using the secret "d" word much more often over the next five
years. By the end of that time, they will also be using its cousin "d" word,
depression.

Robert Prechter is the founder and president of Elliott Wave
International, the world's largest financial forecasting firm. The rest of
EWI's 40-page report, The State of the Global Markets - 2013 Edition: The
Most Important Investment Report You'll Read This Year, is available for download. Follow
this link to download the full report - for free.

This article was syndicated by Elliott Wave International and
was originally published under the headline . EWI is the world's largest market
forecasting firm. Its staff of full-time analysts led by Chartered Market
Technician Robert Prechter provides 24-hour-a-day market analysis to institutional
and private investors around the world.

Robert Prechter, Chartered Market Technician, is the founder
and CEO of Elliott Wave International, author of Wall Street best-sellers Conquer
the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist
monthly market letter since 1979.

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